Thursday, November 28, 2013

Despite The Sell Off, Lowe's Looks Good Value

Investors in Lowe's  must have felt they were living in some kind of parallel universe after the company's excellent set of results were greeted by a 6.2% markdown on the day. As ever, the usual knee-jerk response from journalists was to seek out any possible negative in the company's report or commentary. Lowe's results were a lot better than many made them out to be.

What really happened?
Perhaps the most relevant news on Lowe's results was the old news! The stock had such a major run up before the results that almost anything it said could somehow have been construed as a disappointment.

Not only had Lowe's share price increased by more than 50% in the last year, but it was also outperforming its main rival Home Depot .

HD Chart

While it's true that economic commentators have been becoming a little more cautious on the housing market due to higher interest rates, you certainly wouldn't have noticed it from Lowe's stock performance prior to the results.

Frankly, the sell-off after the results looked like a correction of an overbought move and possibly some hedged pairs trading going on with Lowe's versus Home Depot. In other words, traders might have favored buying Home Depot and shorting Lowe's. 

In reality, there were a number of positives from this report.

First, full-year earnings-per-share guidance was raised for the second time this year and now stands at $2.15.

Second, Lowe's management gave a positive industry outlook. Management forecast that growth would persist in the fourth quarter and went on to state "we expect further acceleration of industry growth next year."

Third, it confirmed that its program of product resets achieved around 100 basis points in gross-margin improvement once the product lines "reached stabilization."The reset program is a project to adjust the products the company sells in order to normalize inventories across categories. Stabilization just refers to when it has cleared out the old inventory.

Clearly, the project is working and Lowe's said that only 66% of its business was stabilized by the end of the quarter. Investors can look forward to margin improvements from the remaining 34% in the future, as well as from the 20% of its business that hasn't even been subject to resets yet.

Finally, the makeup of its sales is suggesting industry strength. Lowe's declared that its Pro sales "continue to outpace our [do-it-yourself] consumer." Indeed, only a day earlier, Home Depot said a similar statement when its management declared "the recovery of our pro business continues in the third quarter, our pro business grew at a slightly faster pace than our consumer business." Both companies see this as a sign of cyclical strength in housing.

In addition, Lowe's performed well with its large product categories such as flooring, kitchens, and appliances. This is in line with what appliance makers like Whirlpool  are saying about the marketplace, and customers' willingness to replace appliances that they bought 10 years ago at the height of the housing bubble. It also confirms the positive outlook in the remodeling market index by the National Association of Home Builders.

Weak spots?The report was generally positive, but there were some points of caution. While appliance sales were strong, the level of promotions was significant enough to reduce the gross margin by 10 basis points. Such developments will obviously concern Whirlpool investors, especially as LG has now been added to Lowe's appliance offerings.

In addition, Lowe's has Samsung and LG appliances highlighted on its floors. This is especially relevant given that Whirlpool won an anti-dumping ruling against LG and Samsung earlier this year.

The second possible sore point was that its forecast of 5% full-year comparable- sales growth implies 4th quarter comps growth of around 4%. As the graph shows, this is somewhat lower than the last two quarters.

Source: company presentations

On the other hand, last year's fourth quarter was positively affected by sales due to Hurricane Sandy. Furthermore, the full-year forecast of 5% is an upgrade from the second quarter guidance of 4.5% and first-quarter guidance of 3.5%. It's hardly bad news.

The bottom line
In conclusion, this wasn't a bad report at all. It's just that the stock had run up too much and investor expectations were probably too high Provided the housing market stays on track, the stock looks to be a good value on a P/E ratio of 17.8 times forward earnings as I write. 

Wednesday, November 27, 2013

Time To Buy Patterson Companies

Sometimes investing is about buying go-go growth stocks that are lovingly discussed by the general public, and sometimes it's about buying boring medical supply stocks like Patterson Companies  . Patterson's end markets of dental, veterinary, and medical rehabilitation aren't growing very fast, but the company has taken a number of initiatives to generate growth. Moreover, the underlying business is highly cash generative. It's worth taking a Foolish look.

Patterson beefs up its veterinary supply business
The company reports in three segments, with dental being its largest revenue generator.

Source: Company presentations.

In each of these segments, Patterson has been taking measures in order to generate earnings long-term earnings growth.

Eagle-eyed readers will note that the veterinary division has seen a jump in revenue this year, which is largely due to the $117.7 million contribution from the acquisition of U.K.-based veterinary distributor NVS, from its former parent Dechra Pharmaceuticals. The deal is particularly interesting because unlike its rival Henry Schein    Patterson didn't have substantive international veterinary operations before the acquisition took place.

In recent years, NVS has tended to be a low-growth but highly cash generative business. Dechra's focus has been on expanding sales of its growing veterinary pharma business, and its 87.5 million pound sale of NVS looks like a good deal for both companies. Dechra reduced its debt with the cash while renewing its focus on pharma. Meanwhile, Patterson bought the leading player in the U.K. vet supply market for just 10.4 times its underlying profit. That's an attractive valuation considering that Patterson currently trades on a P/E of 19.3 times forward earnings.

NVS generated 333.2 million pounds (around $539 million) in revenue in its year to June 2013 with 5.5% revenue growth, but has wafer-thin operating margins of 3.3%. It's entirely possible that Patterson can use its distribution expertise and scale in order to generate some margin improvement in the future. Indeed, Patterson is expecting the acquisition to be earnings accretive by $0.03-$0.04 in 2014 alone. More to follow?

Patterson's mixed earnings from dental
In theory, the dental market should provide strong long-term growth for Patterson. An aging U.S. demographic and better dental care (which implies more teeth per mouth to service) should mean increased demand in the future. Unfortunately, dentists don't see it that way at the moment and are reluctant to spend on core equipment. According to Patterson's management on its conference call:

While dental consumable sales were up year-over-year, consumable growth remained sluggish... ...On a macro level, since the economic downturn, dentists have remained cautious about expanding and upgrading their basic practice infrastructure, which includes chairs, units and cabinetry. 

Patterson's dental supply sales were up just 2.5% in the third quarter, with consumables only up 1.7%.  Equipment and software sales were up a more impressive 4.3%, and this is where the immediate growth prospects lie.

Indeed, Patterson has taken measures to accelerate dental growth by expanding its relationship with dental dental CAD/CAM company Sirona Dental Systems . Sirona's CEREC system allows for same-day teeth restorations, and the technology looks set to benefit from strong growth in future years. Indeed, Sirona just gave its full-year results and reported 18% revenue growth with its CAD/CAM and imaging solutions. Its growth is always likely to be lumpy (it's somewhat contingent on the timing of new product releases), but Sirona (and Patterson) should receive a boost from an unlikely source.

Henry Schein recently signed a deal with Sirona's rival E4D Technologies in order to roll out E4D's CAD/CAM technology to various dental practices in the U.S. This could be good news for Patterson and Sirona, because Henry Schein's move (it already distributes Sirona's products in Europe) will help create awareness of the benefits of this class of technology. Ultimately, this could spur adoption of Sirona's CEREC system.

Medical disposals and IT investment
Patterson's medical rehabilitation business is in a tough market as austerity measures impinge on its growth opportunities. Its sales declined 5% in the third quarter, but this is partly due to measures taken to drive long-term earnings growth. In response, Patterson has been disposing of some of its non-core medical assets in a bid to cut costs. Management forecasts that savings equivalent to $0.01 in EPS will be generated by these measures starting in 2015.

And finally, Patterson is investing between $55 million and $65 million in IT over the next five years in order to ensure future productivity gains.

Where next for Patterson?
After excluding the $0.12 restructuring charge taken for its medical business, its internal guidance is for $2.13-$2.24 in EPS for the year to April 2014. This puts the stock on a P/E ratio of 19 times forward earnings. This may seem expensive but recall that Patterson has generated an average of $264 million in free-cash flow over the last three years. This equates to around 5.8% of its enterprise value as I write.

In conclusion, Patterson has been busy engaging in "blocking and tackling" initiatives to improve its productivity in medical. Veterinary has seen the acquisition of NVS, and its dental segment has expanded its relationship with Sirona. All three measures are set to increase its long-term potential, and Foolish investors should look favorably on the stock.

On Assignment, Kforce and Robert Half Look Set to Outperform

Despite some of the doom and gloom in the press, the economy is slowly recovering and investors are being rewarded for buying cyclical stocks. As such, staffing companies look like a good place to be invested. Not only is the economy helping the likes of Robert Half   , but there are some secular growth trends helping, too. In particular, a technology specialist like On Assignment   is managing to grow in excess of its marketplace, and looks well placed for future growth.

Two reasons why staffing is a favorable market
First, the economy is seeing a cyclical recovery in employment. While most observers focus on payroll numbers, the American Staffing Association also issues an index of temporary and contract staffing. Fortunately, the data indicates that 2013 is set to be the best year since 2007.

Source: American Staffing Association

Second, while increases in the staffing index have historically led to a pickup in permanent employment, there are sectors in which temporary staffing looks likely to be stronger than it has been in previous cycles. In particular, staffing companies operating in the science, technology, engineering and mathematics, or STEM, marketplace are likely to benefit from favorable trends.

For example, on its conference call, fellow IT staffing company Kforce's   management quoted data demonstrating that the percentage of temporary workers as a share of the labor force rose to 2.02% in the third quarter (a figure significantly "higher than last cycle's 1.96% peak").

Technology cycles are getting shorter, so corporations are more likely to hire in staffers. Additionally, according to the management of On Assignment on its conference call, companies like Accenture may be susceptible: "We're not saying that we're beating Accenture at project consulting. We're saying that the customer is deciding more often than not now that maybe they should do this on an IT staff aug basis, versus a project consulting basis."

Furthermore, if the skill sets required in STEM employment are becoming increasingly differentiated, companies will be more inclined to carry out a project by drafting temporary workers, instead of executing it internally. It takes a lot of time and money to train staff with new skills.

Staffing companies generate strong cash flows
In addition to favorable trends, staffing companies tend to convert profits into cash flow very well, and in bad times, the conversion rates tend to rise.  

Note that in the following graph, the free cash flow calculation is simply reported operating cash flow minus capital expenditures. The quoted companies may report this metric differently.

Source: Google finance, author's interpretation

On Assignment is the best pure play STEM staffing company. It competes with Kforce and the technology division of Robert Half, and all three companies look set to deliver strong performances this year.

In its latest third-quarter results, On Assignment delivered consolidated revenue growth of 15%, with Apex (a mission-critical IT staffing company acquired in May 2012) generating a 22% increase, and Oxford (a high-end IT and STEM company acquired in 2007) generating a 14% increase. Apex and Oxford made up 80% of On Assignment's revenue in the quarter, and management predicts fourth-quarter revenue growth of 12.8%-13.8%.

In comparison, Kforce's technology unit, called Tech Flex, represents around 63% of revenue, and it grew at a healthy 14.2% in its last quarter. Kforce's total company revenue is expected to grow by 12% in the quarter. Robert Half is more of an all-purpose staffing and recruitment company, and its technology segment only makes up around 12.3% of the company's total revenue. Nevertheless, recent results confirmed the trends discussed above, with Robert Half's technology revenue growing at 11.8% in the quarter, versus only 2.5% for the total company.

Kforce, On Assignment, or Robert Half?
The staffing industry is in good shape, and all three are forecasted to substantially grow earnings next year. If you are looking for international exposure across a range of industries, Robert Half's valuation of 17.9 times forward earnings should be attractive.

Foolish investors who prefer more of a STEM focus will be guided toward On Assignment, especially as it's forecast to grow earnings by 19% in 2014. The stock trades on a valuation of 22.6 times forward earnings.

Meanwhile, Kforce's growing technology segment is expected to lead the company toward $1.17 in EPS next year, putting it at 16.9 times forward earnings. All three tend to generate significant free cash flow in excess of profits, and they all look like good potential purchases for the cyclical end of your portfolio. 

Tuesday, November 26, 2013

Nordstrom's Long Term Growth Plan

Deciding whether or not to invest in a high-end clothing retailer like Nordstrom   used to be easy. In the past, it boiled down to your view on the environment for higher-income consumer spending. Although that argument is still applicable, it's far from the full picture now. Nordstrom is undergoing some fundamental changes in its business, and Foolish investors need to consider what this company will look like in a few years.
Nordstrom adjusts to a changing environmentThe retailer is best known for its full-line stores. However, its investment plans for the next five years involve shifting sales toward its other sales channels. The idea is to move toward the kind of growth trends that seem to have categorized the US consumer since the recession.
For example, off-price retailers like TJX Companies   and Ross Stores have been flourishing, while mid-market department stores like J.C. Penney are struggling. In response to these trends, Nordstrom is investing in its off-price concept, known as the Rack. Nordstrom is also imitating clothing companies such as VF Corp   and Coach, which are investing significantly in their online strategies.
Unfortunately, Nordstrom is having some teething problems. Its third-quarter results were a disappointment, with its full-line stores delivering a same-store sales decline of 4.2%. Moreover, it lowered its full-year earnings per share guidance to $3.60-$3.70 from a previous estimate of $3.65-$3.80. The question is if Nordstrom's investment plans are making it lose its focus on its core business.
Nordstrom's growth plan
Nordstrom's plan involves ramping up capital expenditures to $3.7 billion over the next five years in a way that changes the way it does business.
Source: company presentations
Key parts of the plan include:
  • Expansion of its Rack outlets (20% of total sales) to at least 230 from 127 today
  •  Invest in IT infrastructure initiatives in order to expand its e-commerce sales, and increase stock keeping units, or SKUs, in its online offerings
  • A combination of investment in Canada and its US flagship stores, such as the store in Manhattan

Nordstrom and the retail environmentIn order to illustrate the importance of the plan, here is a breakout of Nordstrom's same-store sales data. Note that the direct division includes Nordstrom's own online sales (11% of total sales) plus sales from Haute Look (2% of total sales), an off-price online company it bought in 2011. The numerically aware will have calculated that Nordstrom's full-line stores currently contribute 67% of total sales.

Source: company presentations
Clearly the biggest issue is with Nordstrom's full-line sales. It is true that Nordstrom's anniversary sale took place in the second quarter -- last year it was across the second and third quarters -- so its third quarter numbers were expected to look weak. However, Nordstrom's full-line sales have been weak for four quarters now.
When pushed on the issue in its conference call, management stated
We don't believe it's attributable to any one factor. That said, we know customers respond to freshness and fashion, and we're working to provide that, combined with ongoing efforts to enhance the store environment and overall execution.

This sort of performance and commentary captures the problem facing many retailers in this environment. If you are not a differentiated specialty store, then consumers want discounts to buy from you. On the other hand, if you discount too much then consumers will lower their perception of the value of your higher ticket items.
In this scenario a clothing company like VF, which owns Vans, The North Face, and Timberland, can do well because its outdoor action clothing lines are differentiated. It's also growing its online business. VF has a lot of upside potential, particularly if winter is cold this year. VF's main strength is the ability to invest adapt to changing market conditions because it has a diverse set of brands. In addition, its relatively low penetration in emerging markets (particularly with its jeanswear) means it should be able to generate growth through expansion alone.
Meanwhile, off-price retailer TJX has been raising guidance throughout 2013, and it continues to benefit from consumers seeking discounted prices. In fact, TJX just beat analyst expectations with its third quarter results, and raised its long-term estimates for its store expansion program.

What's next for Nordstrom?Nordstrom's strategy is to try and retain premium pricing in its full-line stores while growing its off-price business through Rack expansion. Unfortunately, it looks like its core full-price store growth is weakening, even while direct and Rack sales are expanding.
In a sense, Nordstrom's management should be commended for aggressively making the changes necessary to navigate its way through changing end markets. However, the expansion plan contains execution risk and will eat into cash flow in future. Cautious investors will want to see a turnaround in Nordstrom's core full-price stores before buying in. 

Monday, November 25, 2013

Rackspace's Business Model is Being Challenged

There is a difference between saying that a company is good, and saying that it is a good investment. In the case of Rackspace , its current business trajectory is suggesting that it's not a good investment even though that doesn't mean it’s not a great company. Unfortunately, increasing competition within the cloud computing provision market from the likes of Amazon Web Services  and Microsoft's   Azure is threatening Rackspace, even as the company improves its already high level of service.

Rackspace's margin
It's difficult competing with Microsoft and Amazon in the best of times, but it's a lot harder when they are both cutting prices in order to win market share in a fast-growing business. Throw Google into the mix and its almost unfair. The fact is that those three tech giants can easily subsidize lowering prices (and therefore margins) because they have add-on advantages to winning new business.

Indeed, AWS is reported to have recently cut prices by 10% across all its regions, and it's hard not to think that its response to Microsoft's aggressive discounting actions. The two companies have seemingly been locked in a price battle, the effects of which are starting to show in Rackspace's margins.

While its revenue was up 15.6% in the third quarter, Rackspace's operating income margins fell to 9.4% for the first nine months compared to 12.9% last year. Moreover, the third quarter saw operating income margins come in at just 7.1%.

Rackspace invests in order to grow
In defense of the company, it's currently investing to support growth created by customers adopting its OpenStack public cloud options. In addition, its management has long claimed that its "Fanatical Support" is its unique selling point within a competitive industry. Unfortunately, a high level of support usually implies a high level of investment, and Rackspace appears to be running hard in order to stand still on that front.

At the start of the year, Rackspace had forecast full-year capital expenditures of $375 million--$445 million and customer gear expenditures of $235 million-$275 million. Fast forward to the latest results and capital expenditures are now forecast to come at $460 million--$510 million. While "north of $10 million" of the increase is due to buying land for a datacenter, the rest is because it is investing in its cloud infrastructure and customer gear. In fact, customer gear expenditures have already hit $233 million this year. It's safe to assume that they will come in higher than the forecast at the start of the year.

These facts play to the heart of the questions with Rackspace. Can it leverage up its investments and start to generate meaningful cash flow in future? Alternatively, is it forced to invest in continually buying customer gear so that its customers can benefit from outsourcing IT expenditures in order to generate growth?

The following chart shows operating cash flow, capital expenditures, and customer gear expenditures as a share of income over its last four quarters. The hope is that Rackspace will be able to generate free cash flow (operating cash flow minus capital expenditures) over time.

Source: company presentations, author's analysis.

Unfortunately, it looks like Rackspace is finding it difficult to generate meaningful cash flows. As 2013 has gone on, its customer gear requirements have gone up. Consequently, customer gear now makes up nearly 67% of capital expenditures. Its one thing to provide fanatical support to generate revenue growth, but it's another thing to generate cash to be returned to shareholders.

Rackspace's bottom line
All told, conditions look like they are getting tougher for Rackspace. Competition from Microsoft and Amazon appears to be pressuring prices, while it's having to increase expenditures in order to service clients.

Rackspace has generated just $18.7 million generated in adjusted free-cash flow (its own figures) so far in 2013, but sits on a current market cap of $5.9 billion. Meanwhile, it still hasn't demonstrated that its business model can generate the kind of cash flows that could justify its valuation in future. It doesn't look like a good value to me.

Friday, November 22, 2013

Commercial Construction Is Looking Hot For 2014

If history is a useful guide, the housing recovery should lead into a pickup in commercial construction. With this in mind, well-known companies like building materials specialist CRH  or water heater manufacturer AO Smith  should be obvious beneficiaries. 

Why commercial construction will be strong in 2014
While a lag between an increase in residential activity and commercial construction is only to be expected, it's fair to say that the recovery in the latter has been somewhat disappointing in 2013. However, industry surveys and construction data are suggesting that commercial construction could be about to turn.

This chart compares U.S. new housing starts to how many months' supply of new houses the U.S. has. The lines should mirror each other, because if the housing market is seeing strengthening demand, then the months supply of housing available (blue line) should be falling. Consequently, home builders should be induced to build new housing (orange line) so that line should be going up. With around five months supply at present, history suggests that housing starts should be a lot higher going forward.

US Months Supply of New Single Family Houses Chart

U.S. Months Supply of New Single Family Houses data by YCharts

And while residential housing is recovering, commercial construction appears to be finally kicking in. For example, here is the Architectural Billings Index, or ABI, from the American Institute of Architects. It's the most closely followed construction index. Fortunately, its indicating that commercial activity has finally picked up after a weather-affected spring.

source: American Institute of Architects

In addition, the banks are starting to report increased commercial real estate loan demand.

The following chart represents the net percentage of domestic banks that are reporting increased demand for loans.

Source: Federal Reserve

Note that commercial real estate demand has been strong, and outweighed Commercial and Industrial, or C & I, loans this year. This is unusual, and it could be a negative sign. But it could also owe to the strong state of U.S. corporate balance sheets, plus some reticence to invest thanks to political uncertainties.  

Which stocks to look at, and what they are sayingCRH is one of the world's leading building-materials companies, and its recent results perfectly matched the ABI data above. Its first-half U.S. sales were down 1%, mainly due to poor construction weather, but it recorded a 4% like-for-like increase in the third quarter, and it's expecting "a continuation of an improving trend in the U.S.". In an added plus,  it even discussed some stabilization in Europe.

While CRH is focused on building frameworks, Armstrong World Industries  is a leading flooring and ceiling company. In its third quarter, Armstrong saw its wood flooring rise 20.9% on the back of increased new residential construction. Meanwhile, its ceilings business (which is more affected by commercial office construction and represented 46% of sales in the quarter) saw sales up only 2.9%. If the commercial market improves next year then it's reasonable to expect better conditions for Armstrong.

AO Smith's water heating solutions are seeing strong demand. Its sales were up 16% in the third quarter, causing it to raise its full-year guidance for a third time this year. Moreover, its commercial unit sales surprised on the upside. From its recent conference call:

we've continually raised our estimates on commercial, and we just have much more difficulty kind of estimating that. I think last quarter, we set 154,000 units compared to last year's 147,000. And now, because of a very strong third quarter in commercial, we're going back to the drawing board and we've raised it to 157,000 units.

Heating, ventilation and air conditioning, or HVAC, is another vital component of any commercial building, and Foolish investors might be interested to look at stocks like Lennox International    or Regal Beloit. Lennox recently reported 13% constant currency growth in its residential business, and 8% in its commercial. Moreover, on its conference call, its management spoke of an "acceleration in in our commercial business in the third quarter". 

Lighting is another area that Foolish investors should look toward. Stocks like LED play Cree or North America's leading lighting company, Acuity Brands     look set to benefit from the secular move toward LED lighting, as well as a pickup in commercial building. Acuity has been doing very well this year; largely from the residential market. But its true strength is in the commercial and industrial sector. Analysts already have it on nearly 10% revenue growth to Aug. 2014, but those estimates could easily be taken higher if my thesis right.

The bottom line
In conclusion, anecdotal evidence from companies exposed to the sector as well as industry data are suggesting that commercial construction is likely to improve in 2014. Of the stocks discussed above, Armstrong World Industries looks the best value.

AOS PE Ratio (Forward 1y) Chart

AOS P/E Ratio (Forward 1y) data by YCharts

Its also the stock with the strongest gearing toward the commercial construction sector. Its wood flooring margins will suffer with if lumber costs go up, so keep an eye on that. However, should end demand pick up as expected -especially with its commercial ceilings- then the stock has good upside in 2014.

Is Whirlpool a Buy?

If you like the recovery in the US housing market then you probably like the household appliance makers too. Indeed, the recent results from home goods manufacturer Whirlpool   served notice that the industry is in strong shape. However, is all the good news already priced in? Whirlpool is up nearly 35% year to date, is it now time to take some profits? How does it compete against other consumer goods companies, such as General Electric    and Stanley Black & Decker, for your investment dollars?

Whirlpool increases guidance
The recent third quarter results were pretty upbeat. For the second quarter running, Whirlpool increased its full-year earnings per share and free cash flow guidance.

Full-Year Guidance First Quarter Second Quarter Current
EPS $9.25-$9.75 $9.50-$10.00 $9.90-$10.10
Free Cash Flow (million) $600-$650 $650-$700 $690-$710
source: company presentations

Note that the mid-point of EPS guidance has risen by 5.3%, but free cash flow estimates have gone up by 12%. This indicates Whirlpool's opportunity to grow cash flow in excess of its earnings growth. In the long-term it aims to generate revenue growth of 5%-7%, earnings growth of 10%-15%, operating margin of 8% (which it reaffirmed it would deliver in 2014), and free cash flow generation of 4%-5% of revenue.

To put these numbers into context, Whirlpool's operating margin (excluding restructuring costs) was 7.6% in the quarter, and the forecasted free cash flow for 2013 would represent around 3.8% of revenue. In other words, there should be more to come next year in terms of earnings and cash flow as Whirlpool approaches its targets.

Believing the numbers
However, it's one thing for a company to have targets and another for investors to believe it can hit them. In the case of Whirlpool, Foolish investors have a number of reasons to be positive.

First, the company is seeing growth accelerate in the right areas. Here's a look at how its industry demand assumptions have changed this year.

Full Year Industry Demand First Quarter Second Quarter Current
North America 2%-3% 6%-8% 9%
Europe flat flat to (2%) flat
Latin America 3%-5% 1%-3% 1%
Asia 3%-5% flat (2%)
source: company presentations

Clearly, it's a story of North America strengthening while the other regions are weakening. The good news is that Whirlpool generates most of its profit from North America anyway.

Source: company presentations

Whirlpool generates less than 5% of its sales from Asia, so the weakness in emerging markets that DIY equipment maker Stanley Black & Decker reported recently doesn't apply so much to Whirlpool. Stanley Black & Decker's problem is that emerging market expansion is expected to make up $300 million of its expected $850 million revenue increase over the next three years. Moreover, it is having some integration issues with its acquisition of a European security company, Niscayah.

Second,  the housing market is coming up against the 10 year anniversary of the boom years. If you figure that household appliances have a working life of around 10 years then there should be a significant amount of machines that need replacement in the next few years.

Indeed, the National Association of Home Builders Remodeling Index indicates strength for the industry.

Source: National Association of Home Builders

Third, the rest of the industry is reporting positive results as well. For example, General Electric saw an 11% rise in its appliance sales in the last quarter. In fact, GE has accelerated its appliance sales growth throughout the course of the year, and this nicely mirrors how Whirlpool has increased its North American growth estimates.

  First Quarter Second Quarter Third quarter
GE Appliance Sales Growth 3% 8% 11%
source: company presentations

Where next for Whirlpool?
The next few years look good for Whirlpool, provided the US housing recovery stays on track. Moreover, the stock looks to be a good value. For example, the 2013 free cash flow forecast of around $700 million represents 5.3% of Whirlpool's enterprise value.

Furthermore, if the company hits its target of an 8% operating margin then it will be generating significantly more cash flow in future years. With the housing recovery looking like it is still in its early innings there is more upside to come for Whirlpool.

Wednesday, November 20, 2013

Whole Foods Still Isn't Good Value

hings usually turn nasty when growth stocks stumble, and specialty grocer Whole Foods Market's  latest fourth-quarter results were bad enough to see the stock initially marked down more than 10%. The market obviously believed the company's problems to be industry-wide issues, because sector rival The Fresh Market  was sent down nearly 7% in sympathy. Is the market right to conclude it's an industry issue? And is this a short-term buying opportunity in a long-term growth story?

What went wrong with Whole Foods?
As with all retailers, the key metric to follow is comparable-same-store sales. Unfortunately, Whole Foods managed to miss estimates and reduce guidance for 2014. Its previous outlook was for comparable-same-store sales of 6.5%-8% in 2014, but the weakness in the fourth quarter caused management to lower projections to 5.5%-7%.

Source: company presentations
Moreover, according to management on the conference call:

This change in trends ... ... were seen in both transaction count and basket size and was broad-based across geographies, departments and storage classes.

Why it's a short term issue...
Naturally, analysts were all over the issue during the conference call, but management failed to give a definitive view. In fact, they cited a number of reasons:

  • Strategic price-matching initiatives

  • Cannibalization of existing Whole Foods stores, with Boston specifically cited

  • Weakness in consumer sentiment

  • Increased competition

The first three reasons might make you think this is just a temporary dip in fortunes. For example, the pricing initiatives made at the end of the third quarter did affect sales, but according to the company they will drive growth in the long term.

Furthermore, cannibalization is an issue that can be addressed by better selection of new store locations. As for consumer sentiment, this could turn out to be a short-term issue related to fears over the government shutdown, among other factors.

This viewpoint is strengthened when looking at what Starbucks  recently reported on its trading conditions. The coffee shop is always compared to Whole Foods because both companies tend to serve an aspirational clientele. Indeed, the companies have ties because Starbucks is now retailing some of its products in Whole Foods locations. With Starbucks recently reporting 11% growth in the US and its strongest comparable growth in Canada in more than three years, it was reasonable to think that Whole Foods would report good numbers.

...and why it isn't
Foolish investors might like to think this is a merely a blip in the Whole Foods growth story, but there are three reasons why they should be concerned.

First, back on Aug. 28, The Fresh Market only reported 3.4% comparable-same-store sales growth, a figure that is noticeably lower than the mid-point of its long-term target of 3%-5% growth. Another worrying sign was that its new store productivity (the ability of new stores to generate revenue per square foot compared to existing stores) was only 79% in the quarter, where its target range is 80%-90%. Both figures are indications of an increasingly competitive market.

Second, the strategic price-matching initiative was made in order to "address a couple of competitors in particular," according to Whole Foods CEO Walter Robb. Again, this is a sure sign of encroaching competition.

Aside from the other specialty grocers, mainstream grocers like Kroger    have been targeting the organic- and natural-food market. For example, Kroger launched its Simple Truth brand in 2012, and executives are now disclosing that it's close to being a $1 billion brand.

Finally, the Starbucks analogy is not necessarily a good one. While it's true that Starbucks and Whole Foods offer a high level of service and retail satisfaction, there is a key difference between them. Starbucks sells its own branded products, while Whole Foods sells products that can be bought at Kroger or elsewhere. This leaves Whole Foods a lot more susceptible to competition, particularly in a highly competitive category like food. When Starbucks' customers are in the shop, they might not tend to make price comparisons because they can't buy Starbucks products elsewhere.

Where next for Whole Foods?
All told, this doesn't look like a short-term issue for Whole Foods or even for The Fresh Market. On the other hand, investors shouldn't conclude that it's all doom and gloom from here on out. Most retailers would envy Whole Foods' updated forecast of 11%-13% sales growth in 2014, and the secular trend towards healthier and more organic food doesn't seem like it will end anytime soon.

However, the stock simply isn't priced for any sort of future disappointment. Even at a price of $57 per share, the stock still trades at a P/E ratio of more than 33 times forward earnings. Given the downward pressure on its comparable-same-store sales, it doesn't look like a compelling value play.

Cisco Is A Good Value Trade

Shareholders in Cisco Systems  saw their investment crash after lackluster first-quarter results. The stock is now down around 20% from its yearly high in August. With the mid-point of its 2014 guidance implying a 1% fall in earnings, is now the time to give up on the stock, or to buy in?

Cisco's nasty quarter
Cisco beat earnings estimates for the quarter but missed revenue expectations, and its near-term outlook is horrible. Its orders in the quarter were $600 million -- $700 million short of its own expectations -- a problem for a company with 70% of product revenues dependent on new orders each quarter. With this shortfall in place, its second-quarter EPS guidance of $0.45-$0.47 came in nearly 8% below analyst estimates at the mid-point.

There are two key problems.

First, Cisco basically repeated what IBM   said earlier in the earnings season with regard to demand in emerging markets. Both companies had reported some second-quarter weakness in the BRICs, but IBM's disclosure that its Chinese sales declined 22% in the third quarter -- with hardware down 40% -- was a big surprise.

Fast-forward to Cisco's third-quarter results, and the weakness seems to have spread out. Here is CEO John Chambers on the subject:

Every one of our top 10 emerging countries missed their forecast and was off by a fair amount. So it wasn't just that it was down, the last couple of weeks, they kept dropping and dropping... ... it was over half of our shortfall, the last couple of weeks versus forecast.

Frankly, it's puzzling as to why Cisco's performance in emerging markets was so weak across the board. China was down 18% -- in line with what IBM reported -- but why should Russia and Brazil be down 30% and 25%, respectively?

One possible answer can be construed from something that CEO Chambers mentioned in the conference call. He argued that Cisco went into the last month of the previous quarter "a little bit off the numbers we expected." But in the last two weeks of the quarter, its orders came in $300 million more than forecast. It's possible that Cisco's emerging market weakness was exacerbated in this quarter because in the previous quarter its sales people pushed hard to make the numbers.

The second issue was the 14% fall in service-provider video revenues, while orders also disappointed with a 13% decline. Cisco's set-top box sales declined 20%, and since they make up 20% of revenue from service providers -- which makes up more than 8% of total revenue -- the impact was significant.  Cisco's challenge is to manage the transition from traditional set-top boxes toward its set-top boxes that connect with the cloud. In fact, this has been an ongoing issue this year. It seems that sales of its new products were disappointing, and Cisco continued to follow a policy of "walking away" from low-profit deals with the older technology. Good for margins, terrible for revenue growth.

Four reasons to stay positive?
If you can see a clear pathway through the gloom and doom, there are four reasons why the stock looks attractive.

First, Cisco described its U.S. enterprise and commercial growth as being very strong and cited order growth in the high single digits. This matches what Oracle    said at its earnings in September. Oracle saw its new software-license and cloud subscriptions rise 14% in America. This is a sign that the U.S. -- particularly in enterprise -- is the standout region for IT spending growth. It's a good sign for U.S. growth.

Second, the set-top box issue is a structural problem, but Cisco is managing it, and has products in place. Further, plenty of IT companies see some issues when they introduce new products or make transitions in technology. Companies can be reticent to spend on an old system when a new one is available, yet also careful not to rush to buy and integrate a new technology. However, provided the underlying demand is there, these issues can be sorted out in a few quarters. For example, tech companies like F5 Networks and Check Point Software have seen these issues over the last year.

Third, Cisco was obviously disappointed with its performance in emerging markets, particularly late in the quarter. This means it's likely that the updated guidance has been reset with current trading in mind. If BRIC spending picks up, then Cisco could surprise on the upside going forward. In any case, emerging-market demand does tend to be volatile.

Finally, the company has $48.2 billion in cash and cash-like investments, while total debt is only $16.2 billion. In other words, its net cash of $32 billion represents around 29% of its market cap. Cisco has the resources to make earnings-enhancing acquisitions.

Time to buy Cisco?
Cisco is going to attract value hunters. Even on its disappointing $1.95-$2.05 EPS guidance, the stock still sells at a P/E ratio of around 10.5 times forward earnings. It's not the highest-quality technology company out there, but it's cheap, and it has opportunities to turn around its fortunes. Throw in a near-3% dividend yield and you can enjoy some income while you wait.

Monday, November 18, 2013

Covidien's Growth is Stronger Than you Think

Foolish investors would do well to take a close look at medical device company Covidien  . The company is often ignored by investors in the medical device sector. It doesn't have the glamour appeal of a peer like say, Intuitive Surgical and its surgical robotic systems.  It doesn't offer the familiarity and solidity of having a medical device division within a major company like Johnson & Johnson . Moreover, its forecast EPS growth rate of 7.5% in 2013 is hardly the stuff of legend. So what is there to like about the stock?

Why Covidien's offers more than its peers
Covidien's key attraction is its mix of relatively low-ticket medical device solutions with which it can penetrate emerging markets. This is a major benefit as hospitals and clinics in the developed world are being challenged by austerity measures. A lot of Covidien's products simply fall below the radar of targeted cutbacks. Meanwhile, austerity is hitting the industry hard. For example, Johnson & Johnson only managed to report revenue growth of 0.3% in its medical devices and diagnostics segment, in its last quarter. Its international revenue grew 4.2% with the segment, but US revenue declined by a similar amount.

Meanwhile, Intuitive Surgical's challenge is to convince hospitals and clinics of the merits of its high-ticket robotics solutions. This not an easy task at the best of times, and it's a lot harder when a study like this one from the Journal of the American Medical Association comes out, which claims "Total costs associated with robotically assisted hysterectomy were $2189 (95% CI, $2030-$2349) more per case than for laparoscopic hysterectomy."  Note that Covidien is one of the leading players in laparoscopic instrumentation.

Intuitive has had a difficult year, and it only managed to sell 101 systems in its last quarter, compared to 155 last year. Only 36 systems were sold internationally, of which only six went outside Europe or Japan. It's not looking like an emerging market play!

Covidien's confusing quarter
While Covidien is thematically attractive, its recent fourth-quarter results were not superficially impressive. Adjusted diluted EPS growth was just 5.8% on the quarter, and non-GAAP adjusted operating margins fell 110 basis points. However, you should look beyond these numbers, because the underlying performance is much better. On its conference call, the management outlined:

We delivered adjusted EPS of $0.91 for the quarter, a 6% increase over the prior year, despite the impact of unfavorable FX and the medical device tax. Combined, these 2 items reduced EPS by about $0.10 per share or 11 percentage points

Adding the $0.10 back in EPS gives a far more impressive growth rate of over 17% on the quarter. And on the issue of operating margins:

we declined 110 basis points year-over-year on operating margin. 170 basis points was due to FX and device tax. So we actually would have improved operating margin 60 basis points

The results were a lot better than they appeared.

Emerging markets and supply issues
All told, there were some positive and negative points in the quarter. Its emerging market revenues continue to grow strongly with revenue from the BRIC countries increasing 25%. According to Covidien, emerging markets now make up around 16%-17% of total revenues, and at these kinds of growth rates they are likely to hit 20% of sales by the end of 2014.

On a less positive note, its medical supplies business (around 17% of full-year sales) had a disappointing quarter with US sales down 2%, amid suffering some cost increases due to issues with a supplier. According to the company, the latter issue has been fixed, and it also expects medical supplies volumes to get back into a normal range in upcoming quarters. Its something to look out for going forward.

Where next for Covidien?
Analysts have Covidien on 7.5% EPS growth for 2014, and this is despite facing a headwind from the medical device tax in the first, and ongoing difficult foreign exchange comparisons in the first half. The underlying business is solid, and on a P/E ratio of around 16 times forward earnings the stock is good value for its emerging market growth prospects.

Saturday, November 16, 2013

Digital Realty Trust Signals Problems in the Data Centres

One week after datacenter services company Equinix (NASDAQ: EQIX  ) disappointed the market with a lackluster set of results, it was datacenter REIT Digital Realty Trust's (NYSE: DLR  ) turn to indicate that industry conditions are getting tougher. But is this a short-term growth hiccup or a longer-term problem? And with behemoths like Google (NASDAQ: GOOG  ) and Amazon's Web Services, or AWS, rolling out their own datacenters, are Equinix and Digital Realty headed for more difficulty?

Digital Realty reality
Digital Realty reported funds from operations, or FFO, of just $1.10 in the third quarter compared to analyst consensus of $1.20. FFO is just a metric that REITs use to equate to EPS. Although $0.07 of the "miss" is due to a rent expense adjustment, its core FFO still only came in at $1.16.

Moreover, its guidance for 2014 was disappointing. Quoting from its conference call:

We are revising our 2013 FFO per share guidance to $4.60 to $4.62, down from $4.73 to $4.82 previously, and revising guidance for 2013 core FFO per share to $4.65 to $4.67, down from the prior range of $4.74 to $4.83

This adjustment is a reduction of 3.5% or $0.17 of EPS at the mid-point of guidance, but to be fair to Digital Realty, $0.07 is due to the aforementioned rent adjustment and $0.03 is due to a joint venture with Prudential.

However, the worrying bit is the $0.06 that is due to "delayed lease commitments." In other words, customers are not utilizing the datacenter space—that they signed up for—as quickly as Digital Realty had anticipated. This is a sign of a maturing industry, or at least, one in which the customers have the upper hand with regard to pricing negotiations. Moreover, in its earnings release, Digital Realty gave preliminary guidance for 2014, and informed investors that rental rates on renewal leases are expected to be roughly flat on a cash basis, along with operating margins "approximately 25-75 basis points lower than the historical run rate."

In other words, Digital Realty is finding it harder push through price increases. Another sign of a maturing industry.

Equinix deals with reality
These industry trends are confirmed when looking at Equinix's recent results. There is a more detailed analysis of them linked here.

Equinix had lowered earnings guidance already this year, and its third quarter results also contained some negative nuances. Its deal sizes are getting smaller, while its sales cycles are lengthening. However, Equinix's management argued that it was primarily a consequence of delays caused by enterprises planning more complex hybrid cloud deployments:

I don't believe they are really just driven per se by macroeconomic uncertainty or a broader enterprise anxiety or anything like that... ...just driven by the fact that the decisions of CIOs to move to sort of hybrid cloud infrastructures

Partially in response to these developments, Equinix strengthened its relationships with Microsoft's (NASDAQ: MSFT  ) cloud platform, Azure/and also with AWS. The idea being that Equinix's customers will find it easier to build out their hybrid clouds from within its [Equinix] infrastructure. In fact, Equinix sees the development of cloud services from the likes of Google, Amazon and Microsoft as a net positive in the long-term.

The bottom line
Essentially, the evidence is that the datacenter market is maturing and pricing power appears to be moving away from the datacenter providers and toward the buyers. Meanwhile, its incumbents are still investing in new capacity. Investors in datacenter providers InterXion, Telecity and DuPont Fabros should take note.

Whether the issue is going to be prove relatively short term (as is implied by Equinix's arguments over the hybrid cloud deployment issue), or if it's simply a function of oversupply, the near-term outcome is likely to be similar. The industry is facing some pressures and cautious investors should wait until there are signs of pricing power returning.

Friday, November 15, 2013

Walgreen and CVS will Benefit from Obamacare

Another set of earnings and another solid performance from drug store and pharmacy services company CVS Caremark (NYSE: CVS  ) . The company raised its earnings guidance, and suggested its participation in public and private health care insurance exchanges would make it a net beneficiary of the Affordable Care Act, or ACA. There is a lot to like about CVS and its rival Walgreen (NYSE: WAG  ) , and despite strong share price appreciation this year, they both look like good values.

CVS gets healthier
After delivering better-than-expected performance in 2013, CVS raised its full year EPS forecast to $3.94-$3.97 versus a previous estimate of $3.90-$3.96. In addition, it kept its free cash flow forecast at $4.8 billion-$5.1 billion, and pledged to return $5 billion in dividends and share buybacks to its investors.

How the Affordable Care Act is good news for CVS
While this year's performance seems assured, Foolish investors will want to look forward to see how CVS might fare in the new health care environment. Essentially, public and private health insurance exchanges are marketplaces set up in accordance with the ACA. They are being created to offer personalized health care plans in a standardized and regulated way. CVS is the second biggest pharmacy benefits manager, or PBM, after Express Scripts (NASDAQ: ESRX  ) .  One possible concern with both companies is that they may lose some business as a consequence of employers moving their employees to the new exchanges.

In its earnings presentation, however, CVS outlined why it sees itself as benefiting from the ACA.

  • In the public health exchanges, it will participate as a PBM via its health plan clients, where the client offers pharmacy benefits as part of an integrated plan.

  • It will act as a PBM via its health plan clients within private health exchanges as well.

  • It will act as a stand-alone PBM where it can offer direct prescription offerings in other situations.

  • CVS is already the leading player in managed Medicaid, so any expansion of that program should allow it gain business.

In other words, CVS is positioning itself to benefit from health care reform.

In any case, it may not turn out to be as big of a shift as many think. For example, CVS and Express Scripts are both forecasting that employers will be reluctant to shift employees to the private exchanges.The thrust of the argument, as outlined by Express Scripts CEO George Paz, is that employers will not want to make the shift because they won't want to pay the cost of risk coverage.

Employers have to pay 60% of the total cost of medical services in order to avoid a tax penalty. This means that the employer's risk goes up because it could losing control of what plans its employees are buying. If the cost of the plan goes up over time, possibly because the employee didn't buy a suitable plan, then the employer will still have to meet 60% of the rising cost.

Express Scripts predicts that "private exchanges represent less than 0.25% of prescriptions in 2013 and are projected to reach approximately 2% by 2016." CVS management forecasts:

Well, the fact is that less than 1% of covered lives are expected to move to private exchange products in 2014. And based on conversations we have had with our PBM clients and private exchange partners, we believe that most large employers are taking a wait and see approach to private exchanges, particularly with their active employees.

In other words, CVS and Express Scripts are positioning themselves to benefit should there be wide-scale shifts from employees. Even if this shift doesn't take place, they can benefit from lower income groups getting insurance.

Walgreen and CVS set to benefit
Unlike CVS, Walgreen doesn't have a PBM operation anymore. There is another catalyst to growth from the ACA, however. The reforms are likely to lead to more people being insured, and this should drive prescription demand for the drugstores.

Walgreen is aggressively transforming its business in preparation for these reforms. A big part of Walgreen's plans is to offer services whereby they administer ongoing treatments for indications like diabetes or rheumatoid arthritis, and CVS is doing the same with its MinuteClinics. Again, if more people are covered for these kinds of treatments (recall that the exchanges require standardized coverage) then CVS and Walgreen will benefit.

The bottom lineAll these stocks look attractive from a valuation perspective. CVS may seem expensive in the following chart, but consider that this is a trailing chart and CVS is expecting to generate 37% of its free cash flow for the year in its fourth quarter.

ESRX EV to Free Cash Flow (TTM) Chart

Moreover, all of these companies have double-digit earnings forecasts for 2014. With Obamacare looking set to provide them with opportunities, they all look like good values.

Wednesday, November 13, 2013

Time to Buy Roper Industries

Industrial conglomerate Roper Industries (NYSE: ROP  ) serves end markets as diverse as toll roads, water handling systems,oil & gas drilling, and medical imaging. But Roper underperformed the market this year, rising less than 10%, and also recently cut its full-year guidance. Despite those setbacks, however, its management has successfully continued its long tradition of integrating acquisitions, while squeezing every last penny of profit from its ongoing businesses. Let's review five key reasons why the stock's current slump could actually be a buying opportunity.

Roper Industries lowers guidance
The company started the year expecting 13% to 17% in EPS growth, and 8% to 10% in revenue growth. But analysts have now downgraded their full-year expectations to 13.1% and 8.5% respectively. Essentially, Roper was forced to guide the market lower due to a combination of weaker-than-expected performance at its nuclear business, Zetec, and some weakness in oil & gas drilling activity in the US. The market didn't like these developments, but in the long run, Foolish investors just might.

Five reasons to buy Roper Industries
First, Roper's order book and backlog is in excellent shape. Orders grew 18% in the quarter, and with a backlog of more than $1 billion, there should be plenty of growth to come next year.

Second, the weakness at Zetec is due to some unexpected nuclear plants being shut down, and a corresponding lack of orders for its testing equipment. Roper's management expects these issues to continue into the fourth quarter, this part of the company could easily bounce back in 2014.

As for the weakness in US oil & gas drilling, the best way to gauge industry conditions would be to look at the oil services company Baker Hughes' (NYSE: BHI  ) North American rig count data. This metric is the most widely followed indicator of North American drilling activity. In other words, if Baker Hughes is reporting strength, then Roper could expect to see some future improvement, too.

Source: Baker Hughes presentations
The count seems to be stabilizing, and Baker Hughes believes it will only decline 2.5% in the next quarter. However, companies can still generate growth if they innovate, and Baker Hughes actually saw record revenues for its North American drilling services thanks to "innovative products and services".  In a similar vein, Roper has a new drilling product called DuraTorque, which is "doing very well" according to Roper's CEO, Brian Jellison. DuraTorque has good chances to succeed, because it's aimed at an area of the market (larger-sized directional drilling) that thus far hasn't lived up to Roper executives' expectations.

Third, Roper's most profitable segments are outperforming the rest of the company. Here is a breakout of its operating profits for the third quarter.

Source:company presentations

In the third quarter, energy operating profit declined 4% and its industrial technology profit was flat. On the other hand, RF technology saw profit rising 15% while its medical and scientific unit recorded a 64% increase in operating profits. The latter was helped by contributions from Sunquest, which makes medical information software. Nevertheless, organic revenue growth remained at 3%. As for its RF technology segment, Roper forecasts double-digit organic growth in the fourth quarter.

Fourth, a lot of Roper's other end markets are seeing strong growth. Medical imaging solutions and RF technology (particularly for toll roads) are forecast to have "solid growth" in 2014, according to Roper's management.

Moreover, if housing starts continue to climb, then Roper's metering and water handling solutions (industrial technology segment) should see some upside in 2014.

One of its peers, Watts Water Technologies (NYSE: WTS  ) , recently gave an outlook which I would only describe as being cautiously optimistic. Watts generates 60% of its sales from residential & commercial flow control products, so just like Roper's water handling systems, it relies on construction activity for its growth.

The increase in new US housing starts in 2013 has been a strong support to Watts' residential business, but housing starts have stalled to around 900,000 (annualized rate) due to interest rate increases in the US. Watts is predicting that starts will return to 950,000 by year end , and that "the anecdotal evidence we're seeing suggest that the nonresidential construction market is likely to turn sometime next year." If Watts is right, then Roper could see some, upside too .

And finally, Roper's management has managed to improve its operational performance, despite having to reduce guidance. For example, its cash flow conversion has gotten even better, enabling the company to keep its full-year operating cash flow guidance at $800 million. In addition, the Sunquest acquisition that Roper made in 2012 has bedded in well. Given Roper's acquisition history and current cash flow generation, you can expect more deals to come in 2014.

Where next for Roper Industries?
Roper's valuation doesn't look cheap in relation to some of its peers.

ROP PE Ratio (TTM) Chart

ROP P/E Ratio (TTM) data by YCharts

However, analysts have 12% earnings growth forecast for 2014. In other words, if it ends 2014 on "fair value," then the stock price will be up 12%, and there may be upside to these estimates.

Looking forward, Roper will want to see a snap-back in nuclear activity in 2014, some stabilization in US oil & gas drilling, and a pickup in US construction activity. All three look like decent assumptions. Roper expects the nuclear plants to be reopened, the Baker Hughes data is suggesting conditions are bottoming, and housing construction continues to grow.

There's a strong argument that Roper's current dip makes the stock attractive. At least, I hope so -- because I bought some.

McDonald's And Yum Are Facing Tough Headwinds

This has been a challenging year for the fast food sector, and recent events have suggested that conditions are actually getting worse. Consequently, McDonald's (NYSE: MCD  ) and Yum! Brands (NYSE: YUM  ) are notable under-performers this year, but with much of the bad news already priced in, is this the time to take a contrarian view?

Fast food, slow marketsThere are four main issues that have troubled the sector this year.

First, the bifurcated economic recovery in the U.S. has hit the quick service restaurant, or QSR, sector particularly hard in 2013. Indeed, the issue was specifically discussed in McDonald's last conference call: "We continue to experience a bifurcation of the consumer base. McDonald's core customers skew toward those customers whose disposable income is not rising as much and are spending a little bit less in QSR."

Essentially, there are three ways of examining this issue. The bears will see it as portending an economic slowdown next year. A more optimistic view sees the recovery in the QSRs customer base as merely lagging higher income groups. In other words, growth will ultimately return. A third view sees the issue as reflecting some deeper structural unemployment issues in the U.S. economy, which won't be resolved by a little bit more economic growth.

Second, Europe remains a region of weak economic growth. This may not necessarily worry some specialty retailers or companies with the flexibility to adjust their businesses in line with lower growth. However, McDonald's and Yum!'s KFC are definitively going to be exposed to lower-income earners' spending habits.

A look at McDonald's comparable same-store sales growth reveals much about the underlying conditions.

Source: company presentations
Yum! and McDonald's in China
The third and fourth issues relate to China, and they need to be discussed together because it is not clear which one has had the stronger effect on QSR sales in the country. Yum!'s KFC and McDonald's have seen a noticeable weakness in China this year.

Source: company presentations
The question is whether this has more to do with a combination of KFC's chicken quality supply issues and a bout of avian flu in the country, or more with deteriorating economic conditions.

There is a more in-depth look at Yum! Brands here. Its Pizza Hut unit is doing fine in China, and its restaurant margins only declined 1.9% last quarter, despite a 14% decline in KFC sales. The hope is that once the negative publicity surrounding the chicken quality issue subsides, KFC can then get back to very strong growth next year. Moreover, Yum! bulls will likely point to Burger King's (NYSE: BKW  ) recent comparable sales growth of 3.7% in its Asia-Pacific region, concluding that macro conditions are fine and Yum! just needs to execute better.

Unfortunately, this bullish view is starting to look too optimistic. McDonald's reported a comparable sales decline of 3.2% in China. In addition, McDonald's finally bit the bullet and announced a cutback on capital spending on new restaurants this year, with the principle targets being "China and some of those emerging markets."  Furthermore, Yum!'s same store sales growth was slowing even before the chicken supply issue hit in the winter.

As for Burger King's numbers, it's possible that the company experienced growth because it is relatively under-represented in China, compared to Yum! and McDonald's.

Where next for the industry?
In conclusion, conditions don't look like they are getting better for QSR core customers any time soon. The U.S. economy is improving, but the days of McDonald's being a "trading down play" seem to be over. This trading down effect may have worked in 2008, when the middle classes were facing job insecurity and layoffs, but those issues are slowly being resolved. However, conditions remain difficult for lower-income America.

In addition, Yum!'s problem in China has gone on for longer than expected, and it's starting to look like the macro part of it is larger than originally thought. Investors would do well to exercise caution with the sector, as it could get worse before it gets better.

Tuesday, November 12, 2013

Church & Dwight Still Has Upside Potential

f you have any doubt about how difficult the US mass consumer market is right now, you need only look at the third quarter results from Church & Dwight (NYSE: CHD  ) . Its organic sales growth was only up 1.6% amid increasing pricing competition. However, its management team continues to deliver in challenging times. The full-year earnings per share target of $2.79 was reaffirmed. Can it continue to outperform despite a difficult environment?

Church & Dwight's management delivers mixed results
The bad news in Church & Dwight's latest results was the reduction in its full-year organic sales growth estimate to 1.5%-2%. Church & Dwight started the year by forecasting 3%-4% sales growth, and just last quarter the forecast was at 2%. Furthermore, six of the 14 categories that the company sells into experienced lower category sales in the quarter.  In addition, rival household goods company Clorox (NYSE: CLX  ) only delivered 2% sales growth in its first quarter and predicted 2%-3% sales growth for its full year.

Meanwhile, industry end markets remain tough. Church & Dwight may already be feeling the early effects of Procter & Gamble's (NYSE: PG  ) decision to launch a cheaper version of its market leading Tide laundry detergent in 2014.

Indeed, when questioned about the reduction of organic sales growth on the conference call, management cited laundry detergent as being "the key call."  Procter and Gamble's move is intended to take aim at Church & Dwight's value-based Arm & Hammer and XTRA laundry detergents. Consequently, it's understandable if Church & Dwight took pre-emptive measures to strengthen market share before Procter & Gamble launches in 2014.

And now the good news
First, Church & Dwight's Avid (gummy vitamins) acquisition continues to outperform expectations with 20%-plus growth generated in the quarter. Management forecasts "double-digit growth for the foreseeable future." 

Second, Church & Dwight's specialty products saw a return to form with an organic sales increase of 3.7%. Going back to the previous quarter, there had been some weakness attributed to cold weather reducing demand for electrolyte replacement products for cows. However, with a more normal weather pattern in the third quarter this product's sales rebounded.

Third, thanks to ongoing productivity improvement,s Church & Dwight's gross margin continues to grow. In fact, the company's gross margin is now forecast to grow by around 75 basis points for the full year. This is an increase on last quarter's forecast of a 50 to 75 basis point improvement, which in turn was an improvement on the 25 to 50 basis point increase forecast two quarters back. Essentially, Church & Dwight has been progressively generating better margins as the year has gone by. An impressive performance when you consider that the company has been increasing its discounting in response to pricing competition.

What will 2014 look like?
A pessimist will look at the company and argue that the contributions from Avid's gummy vitamins mask weakness in organic sales growth. Moreover, increasing competition from Procter & Gamble in the value end of laundry detergents will pressure Church & Dwight further in 2014. Furthermore, when Clorox came out and announced that its first-half sales will be at the "lower end of our full year range due to competitive activity,"  the conclusion he would draw is that Church & Dwight faces significant headwinds going forward.

On a brighter note, there are plenty of reasons for optimism. The company is promising its "biggest amount of new product launches we've ever had," and the idea is that 2014 will turn into a year where the industry focuses on product innovation rather than pricing competition.

Much of this will depend on overall US GDP growth in 2014 because it's fair to say that US growth was expected to be higher than it turned out in 2013. The upshot of this is that many household products companies were forced into discounting in order to retain market share in 2013. With growth expectations somewhat more muted going into 2014, there may well be some easing of pricing pressures if growth turns out better than expected during the year.

Furthermore, the increased competition from a value version of Tide may spur more interest in the value category and paradoxically lead to increased sales for Church & Dwight's value brands.

Where next for Church & Dwight?
All told, your decision to purchase or hold the stock will partly depend on your level of confidence in Church & Dwight's management continuing to execute well in 2014. Fortunately, history would be on your side should you decide to do this. The company's management has an excellent record of generating market share growth with its leading brands. Moreover, the stock is attractive on a relative value basis.


CHD EV to EBITDA (TTM) data by YCharts

Analysts only expect Church & Dwight's rivals to achieve single-digit earnings growth, while it has analysts penciling in double-digit EPS growth for 2014. Overall, the stock looks slightly undervalued.

Sunday, November 10, 2013

Beacon Roofing Supply Will Have a Better Year in 2014

It's been a volatile year for the roofing industry, and over the last three months, investors have seen more downside. Roofing materials distributor Beacon Roofing Supply (NASDAQ: BECN  ) is down 11.5% in the last three months, and building products manufacturer Owens Corning (NYSE: OC  ) fell 5.5% in the same period -- all in a year when many commentators thought this sector would outperform. 

It's complicatedA resurgent housing market should lead to a marginal increase in new residential roofing demand, while the underlying reroofing demand should provide its usual support. Indeed, these conditions looked like they were in place for 2013, and analysts built a fair amount of optimism into their expectations. So what went wrong?

First, the US has had some unusual weather patterns in recent years. In previous years, hurricane Irene (and to a lesser extent Sandy) helped to generate reroofing demand, while this year's weather has been far more clement. Worse yet, according to Owens Corning, those storms pulled forward reroofing work that homeowners might otherwise have planned to do this year. And this spring's bout of wet weather further hurt roofing activity, because contractors simply couldn't work.

Second, rising mortgage rates have slowed new home sales' growth. For example, according to the U.S. Census Bureau, new home sales were at a seasonally adjusted annual rate of 390,000 and 421,000  in July and August respectively, where the average for the first six months of the year was 445k.

For a number of reasons, you shouldn't give up on housing just yet, but the roofing market remains weakened in the short term.

Problems leaking into Carlisle Companies and Owens Corning
A combination of these developments has dampened market conditions, and ultimately the operational performance of companies in the industry. It's difficult to be a supplier to roofing contractors when end demand is weaker than expected, because it can leave suppliers with too much inventory on their hands. 

For example, Owens Corning had previously expected that the full-year market shipments would be flat.  But in its third-quarter results from Oct. 23  , the company now forecasts that "... we came into the year thinking the overall roofing market should be about flat for the full year, it's down mid-single-digits year-to-date, and we think it'll be probably down mid-single-digits for the full year."

Moreover, Owens Corning has been affected by unusual variations in regional demand caused by the factors discussed above. It argued that US industry volume growth was stronger in Western and Atlantic markets, with weakness in Central regions. Unfortunately, Owens Corning has stronger market share in the Central regions, and weaker in the Western and Atlantic. In response, it appears to have decided to keep margins up at the expense of volume growth. Its roofing sales were flat in the third quarter, while its EBIT margins improved to 20% as EBIT rose 15.6% to $96 million.

Carlisle Companies (NYSE: CSL  ) also has a major construction materials division that supplies roofing products to Beacon. It appears to have taken the opposite approach to Owens Corning, and gone for volume growth instead of  keeping pricing and margins up. In discussing its third quarter results on Oct.22, Carlisle disclosed:

Pricing was negative 3% while volume was up 14%. We also experienced very healthy growth in Europe, where sales were up 11%. Both new construction and reroofing drove sales growth in the quarter.

Carlisle also argued that the pricing difficulties were due to excess capacity in the industry, but that underlying demand remains "very strong." It may well be, but it's also likely that the industry was geared for even stronger growth.

Which stock is the best pure-play on US roofing demand?For a play on a bounce back in North American roofing activity, Beacon may be your best bet. Carlisle is not really a pure-play roofing company, and Owens Corning has struggled to generate significant cash flows over the last few years. Moreover, Owens Corning doesn't have the kind of long-term structural opportunity that Beacon has to consolidate its industry.

Beacon will give its next set of results toward the end of November, and you shouldn't expect too much from them. Having chosen to buy inventory from its suppliers ahead of price increases, Beacon then suffered margin decreases as its growth lagged its previous quarter's forecasts. On the evidence of what Carlisle and Owens Corning just reported, Beacon may be in the middle of a tough quarter right now.

I don't want to be too negative on the stock. On the contrary, I'm looking for a potential buying opportunity. In the longer term, Beacon has many attractive qualities, and the roofing industry looks set for a better year in 2014. But for now, it's a good time to be a little cautious.